Public Borrowing: Effects and Justification

Public Borrowing: Effects and Justification!

Effects of Public Borrowing:

Public borrowing involves transfer of purchasing power from individual to government and a subsequent retransfer of the same to the individuals from the government.

Thus, public debt, in one sense, has the ‘revenue effect’, and, in another sense, has the ‘expenditure effect’. This means that public borrowing produces different effects on the economy. However, the exact effects of borrowing will greatly depend on the sources of borrowed amounts.

i. Effect on National Income and Distribution:

It is said that the net effect of government borrowing is expansionary. If loans are raised for productive purposes, scarce resources may be distributed rationally. In other words, resource allocation will take place to sub-serve national interests. Consequently, national income will rise.

But if loans are raised to finance unproductive activities like repayment of loans, resources then may not be allocated in an optimal manner. Even then, the effect of public borrowing on consumption spending is likely to be less adverse. Again, public borrowing does not produce any significant adverse effect on investment. Thus, public borrowing can produce favourable multiplier effect on national income.

Often government imposes taxes to finance its loan repayment programme. High rate of taxes discourages people to work more. Although public borrowing involves transfer of resources (from taxpayers to the lenders), the negative effect of taxes (i.e., desire to work less when taxes are increased) produce an unfavourable effect on income.

Because of debt, present generation obtains less capital. Thus public borrowing is not necessarily expansionary. A lower volume of capital reduces production and productivity of an economy.

It is alleged that public borrowing widens income inequality. As far as loan repayment is concerned, government levies taxes whose burdens are felt more or less by all—both rich and poor. However, burden of taxes is mostly felt by the poor people.

Rich people who lend money to the government earns more interest income than what they sacrifice by paying taxes. Hence inequality widens. However, poor people will be benefited through borrowing programme if the borrowed amounts are spent for their uplift. Only then, inequality will lessen to some extent.

ii. Effect on Price Level:

Whether public borrowing is anti-deflationary or anti- inflationary depends on how the debt affects the money supply and how it affects economic activity. Loans from banks (say purchase of government bonds by commercial banks) lead to an increase in money supply. This will put a great pressure on the price level. In this sense, ‘borrowing is inflationary’.

However, public debt is not necessarily inflationary in character. If public debt is used to raise income, employment and output, the inflationary effect will then be greatly minimized. But inflation, under the circumstance, is unavoidable.

Further, if government borrows money from individuals, rather than banks, then the individual borrowers will be forced to curtail their consumption spending. This will then serve as a good anti-inflationary measure.

Justification for Public Borrowing:

Today, no one believes that public borrowing is wasteful and undesirable. Public borrowing is an important tool of the government to affect economic activities. Even governments of rich countries do not hesitate in raising loans; it does not, however, reflect financial weakness of the government. To carry out its ever-increasing expenditure, a government often incurs debt—both internally and externally.

Public debt is justified on the following grounds:

i. Unforeseen Emergencies:

The government often resorts to public borrowing to meet unforeseen emergencies, like war, flood, drought, etc. Huge expenditures on these national emergencies can never be met by taxation alone, particularly in poor countries where taxpaying capacity of the people is not too high. That is why a short run emergency borrowing is made to tackle these emergencies.

ii. For Economic Development:

Public borrowing is considered to be an important source of development finance. The state is required to build up industries, economic and social infrastructures. The inadequacy of tax revenue has led the government to adopt the borrowing policy to finance these activities.

In this way, public loans are used productively. Further, these economic activities, in the long run, are revenue-yielding. Since they are revenue-yielding or permanent income generator, government borrowing is justified. India’s five year plans have witnessed a massive growth of public debt. For financing various development programmes, planners over the years have relied greatly on this source of financing.

iii. To Curb Inflation:

Underdeveloped countries are inflation-sensitive countries. By resorting to public borrowing, government can siphon off the excessive purchasing power of the public. In an already inflationary situation, since people’s disposable income tends to rise, their purchasing potential also rises.

Under the circumstance, purchasing power of the people can be curbed by resorting to borrowing by the government. However, some economists argue that, as an anti-inflationary method, taxation works better.

iv. To Control Depression:

As a contra- cyclical measure, government borrowing is justified. During depression, economic activity remains at a low level. To stimulate the economy, what is required is the increase in public spending. Public works programmes are one such example of government investment spending. Under depressionary condition, financing of an economic activity through taxation is not advisable.

By increasing the volume of government spending an economy can be stimulated. And, government spending has the multiplier effect on income and employment. Thus, additional government spending financed through public borrowing may revive the economy from a state of depression.

Thus, public borrowing is not necessarily dangerous. On the contrary, public borrowing is unavoidable in certain circumstances. That is why modern governments borrow money from different sources.

But, one thing that is certain is that if volume of public borrowing grows to an abnormal extent, it will then destabilize the economy. Benefits of borrowing or objectives of borrowing will then be defeated. Thus public borrowing has to be made carefully and judiciously.